Save Article

Brokers Promote
Alternative to Mutual Funds

In Bid for Small Investors,
Securities Firms Embrace
Exchange-Traded Funds

By

Ruth SimonStaff Reporter of THE WALL STREET JOURNAL

Updated Oct. 12, 2004 12:01 a.m. ET

Brokerage firms are trying to woo individual investors with new products and services that focus on exchange-traded funds.

ETFs are baskets of securities that resemble index-tracking mutual funds in that they also track the movement of a particular index or sector. But ETFs trade throughout the trading day, unlike mutual funds, whose price is set just once a day. ETFs began as a product aimed at institutional investors, but they have begun to catch on with individuals, because the fees tend to be low. Investors, though, pay a commission on each ETF purchase or sale.

With interest in ETFs growing, online brokerage firms are coming out with new tools and products to help individual investors add ETFs to their portfolios. In addition, some full-service brokers are incorporating ETFs into their fee-based programs.

The Biggest Baskets

Mutual Funds Quarterly

This month,
Ameritrade Holding Corp.
is rolling out Amerivest, an online service that helps investors pick an asset allocation tailored to their risk tolerance, and then, with a click of a button, purchase ETFs to execute that choice. In September,
E*Trade Financial Corp.
launched its online ETF Center, which includes snapshot profiles of 158 ETFs, screening tools and other information aimed at both active traders and long-term investors. To woo active traders, E*Trade also told customers it will execute ETF trades within two seconds or rebate the commission.

Morgan Stanley
will soon begin offering exchange-traded funds as part of its fee-based managed-account program.
A.G. Edwards Inc.
has boosted the offerings of its "Allocation Advisors" program, which was launched in 2002 with four model portfolios of exchange-traded funds designed to fit varied investment needs. The St. Louis firm now offers 14 model portfolios, adding four this spring and five more in September. Assets in the program climbed more than threefold in the 12 months ended Aug. 31, the firm says.

"There is tremendous buzz around ETFs right now," says David Haywood, director of alternative product research at Financial Research Corp., a Boston fund consultant. Brokerage firms "are trying to capitalize on it."

At
Merrill Lynch
& Co., individual investors hold roughly $9 billion in ETFs, up from $4.5 billion a year ago. Barclays Global Investors, a unit of Barclays PLC, says that individuals now account for 60% of the growth in its iShares ETF offerings, up from 40% in 2001. Total assets in exchange-traded funds rose 14% $174.5 billion in August, according to the Investment Company Institute, from $172.1 billion in July.

For many firms, the move toward ETFs fits into a broader shift toward fee-based business. ETFs are "an inexpensive option that allows you to go after a broad swath of the market cheaply," says Michael Kostoff, executive director of the VIP Forum, a Washington research group that tracks the wealth-management industry. "The broker can tell the client, 'I've put you in this ETF product, which is much cheaper..., and therefore I'm earning my fee."

Measuring Risk

At Ameritrade, investors answer six questions designed to measure their risk tolerance and then are funneled into one of 25 model ETF portfolios. The program also allows investors to check how their current asset mix compares with the recommended allocations. To get back on target, investors can just click a button and Ameritrade automatically sells or buys ETFs as needed to rebalance the portfolio and get back to the original asset allocation. Ameritrade is charging 0.5% on the first $100,000 of assets and 0.35% of assets above that amount, with a minimum annual fee of $100.

"We're going after the investor who is interested in a more disciplined portfolio strategy," says Joe Moglia, chief executive officer of Ameritrade, which is known for catering to active traders. Mr. Moglia hopes the new approach will boost Ameritrade's share of its client assets that are kept at the firm, which currently stands at 22%.

Flexibility a Plus

ETFs have won fans for their flexibility and low fees. Unlike mutual funds, whose price is set once a day, the prices of ETFs change constantly during the day because they trade openly on stock exchanges.

Expenses for ETFs that invest in domestic stocks average just 0.37% of assets against 0.73% for comparable no-load index funds, according to Morningstar Inc., the Chicago investment-research firm. ETFs can be more tax-efficient than funds, too.

ETFs have some downsides, however. Because investors pay a brokerage commission on each trade, ETFs generally don't make sense for investors who invest a set amount on a regular basis, a process known as dollar-cost averaging.

For example, an investor would pay $9 a year in expenses on a $10,000 investment in the
iShares S&P 500 Index Fund,
says Mr. Traulsen, compared with $18 annually for the same investment in the Vanguard 500 Index Fund, assuming the value of both funds remains constant. But even at a discount broker, commissions for the iShares fund are likely to run $8 or more, he says, practically wiping out the difference. "If you were to make regular monthly investments at $8 a trade, you're paying $96 to buy into this fund," he adds. (Recent price cuts by Fidelity Investments and E*Trade have further reduced the cost of some index funds.)

Investors who buy ETFs as part of an asset-allocation program can face hefty fees. A.G. Edwards, for instance, charges 1.25% to 2.25% of assets for its ETF-based Allocation Advisors program. Early next year, Raymond James Financial Inc. plans introduce its own asset-allocation program that uses ETFs next year. The company hasn't finalized the pricing, but expects expenses to run 1.5% to 1.75% of assets.

"A lot of these small accounts might be better off simply calling Fidelity or Vanguard and opening an account with them," says Gary Gastineau, an ETF consultant based in Summit, N.J.

Another drawback: ETFs that invest in a single sector of the market or a single country can also be highly concentrated, with 60% to 75% of their holdings in just 10 stocks. That makes them more vulnerable to changes in the price of a single security.

Long-Term Goals

ETFs are often used by active traders who want to quickly take advantage of market moves. But many of the newest offerings are aimed at investors with longer-term investment objectives.

Merrill Lynch says its brokers are using ETFs to invest customer assets in line with model portfolios put together by the firm's strategists. "Financial advisers and registered investment advisers are starting to realize these are going to be the core products for investing for clients," says Tim Strazzini, head of global private-client equity and options.

In addition to using ETFs for their entire asset allocation, some investors are creating a "hub and spoke system" that uses exchange-traded funds as the centerpiece of their investment strategy, and private money managers for exposure to sectors such as international and small-company stocks, says Morgan Stanley managing director Henry Kaplan.

At Raymond James, beginning next year, brokers will receive thumbnail reports on roughly 100 exchange-traded funds as part of the firm's new ETF initiative. The company is also looking into creating similar reports that brokers could send to clients.